Why Canada’s banks are on an acquisition spree

Canadian banks are on an acquisition spree. In October, Royal Bank of Canada scooped up the Canadian auto-lending and deposit business of Ally Financial in a deal valued at US$4.1 billion. Toronto-Dominion Bank plunked down $6 billion for the credit-card portfolio of Target. And in August, Bank of Nova Scotia secured ING Bank of Canada for $3.1 billion.

In fact, the Big Six banks have completed about 50 acquisitions in the past two years, according to Dealogic. A common theme underpins a lot of these moves: consumer lending, the bread and butter of Canadian banks, isn’t as profitable as it once was. “That basically forces the banks to seek new opportunities,” says Brad Smith, an analyst with Stonecap Securities.

Traditionally, the banks have made money by borrowing funds at short-term interest rates, lending out to consumers at higher long-term rates and profiting from the difference. But the gap between short- and long-term rates has narrowed since the financial crisis, squeezing profit margins. Scotiabank’s purchase of ING gives the bank greater access to deposits, a cheap source of funding, so it can try to maximize profits on the interest rate spread. Likewise, part of the appeal of Ally (formerly GMAC) for RBC is that auto loans come with relatively high interest rates. The financing arms of auto manufacturers have also dominated the sector for the past decade or so, while banks have played a limited role. Now they’re stepping in after the recession hammered auto companies.

While auto finance represents somewhat fertile ground for the banks, RBC’s Ally purchase doesn’t address the biggest problem facing the sector: Canadians can’t keep borrowing as they have. The average household debt stands at a record high of 163.4% of disposable income. Moody’s Investor Service recently put five of the six major banks on downgrade watch, in part due to concern about consumer debt. When people finally curb their appetite for borrowing, the mortgage, credit card and auto-lending arms of the banks will all slow down, says Peter Routledge, a financial services analyst at National Bank Financial. “The deal RBC made gives them a bit more earnings,” he says, “but I don’t think it changes the equation at all.”

Banks can respond to dimmer prospects domestically in two ways, according to Routledge: cut costs or expand abroad. That explains why TD is making a huge push into the U.S., where it now has more branches than in Canada. TD has accumulated a lot of deposits through those branches. It’s now working on growing its loan portfolio to maximize returns, which is why it purchased Target’s credit card portfolio and U.S. auto lender Chrysler Financial in 2010. Similarly, Bank of Montreal is expanding stateside.

Many analysts argue Scotiabank, the most international of the Big Six, is the best positioned for the years to come. It has a large business in Latin America, where rising household incomes provide opportunity to grow organically. RBC, meanwhile, is more vulnerable to the coming lending slowdown at home. It’s unlikely that auto finance on its own will be the solution.